Friday, February 17, 2017

Forbes: Shrinking FX Reserves: Will China Defend The RMB?

As we continue to monitor events related to China and the US, Forbes runs this article once again noting the Catch 22 situation China finds itself in with regards to defending its currency and it reserves. Below are a couple of excerpts and then some added comments. See Jim Rickards email comment to me about this issue further below.

"The monthly China debt watch is over and the verdict is in. China's FX Reserves have officially broken through their $3 trillion floor, returning to levels not seen since 2010. The prediction was that this would have to wait until February, but these reserves have been falling relentlessly for seven months straight, and no end yet in sight.". . . . . ."So the question becomes how much of their remaining reserves China can afford to sell in the hope of propping up the yuan? And is this anywhere near the amount needed to change market expectations of mid to long-term currency depreciation? Because if market expectations don't change, China will simply watch its currency depreciate anyway, while its much heralded FX reserves drain further.

Yet if China doesn't prop up the yuan, merely allowing the currency to fall will only reinforce capital flight, drive up import costs and inflation and exacerbate China's long term export dependency, not to mention antagonise trade partners already complaining about a persistently undervalued currency."

. . . . .

"All of which leaves the impression that China is facing an invidious choice; either defend the currency, or defend the reserves. They cannot realistically attempt both, and must accept serious consequences either way."

My added comments: It is clear that this situation China finds itself in is one we need to continue to monitor. Especially in light of the pressure Donald Trump has attempted to put on China in regards to its currency and trade imbalance.

The potential for this to turn into a serious problem and conflict is obvious. On the other hand, President Trump seems to have backed down somewhat from earlier harsh rhetoric on China. I have to wonder if he has become more aware of the problem China has to deal with here and now wants to try and figure out how to work with them rather to put pressure on them (at least in regards to how the deal with their currency situation).

The US dollar continues to show relative strength and this is really becoming a problem for the US, China and the rest of the world that is up to its ears in US dollar denominated debt. Recently both Trump and other Administration officials went so far as to actually try and talk down the dollar.

A too strong dollar will make it much harder for Trump to get results from his proposed economic policies and also will put pressure on nations trying to pay off dollar denominated debt. Ironically, a weaker dollar may be what Trump actually prefers and yet so far the dollar continues to show relative strength.

All this makes me wonder if we might see the following unfold this year in an effort to try and get the US dollar to weaken:

- Trump and Congress look the other way and don't really make much effort to cut US government spending (they get on board with a big "stimulus" program and don't really mind if it runs up the US deficit even more). My guess is the GOP Congress will raise the debt ceiling this time without any complaints if this scenario does unfold. None of the usual political posturing about considering shutting down the government to prevent the debt ceiling from being raised.

- US Fed eventually moves to adopt so called "helicopter money" to fund all this ramped up stimulus spending if need be. Fed just buys any new US debt the market does not have an appetite for and further expands its balance sheet if it has to.

If markets see the above unfold, they might actually finally decide the US dollar is too strong given further expanding US debt and even more easy money policy from the Fed to cover that new debt expansion. All this along with tax cuts might also get the velocity of money moving up and get inflation ramped up more sharply (which means the dollar is losing purchasing power). The combination of all this might get the dollar moving downward where everyone seems to want it to go, but can't figure out how to get it done..

The problem with the above (if it does happen) is that its hard to fine tune this kind of thing. Once you get inflation moving up more sharply and the dollar weakening, the momentum might just carry far beyond any intended targets. Watch gold and silver. If they start moving strongly higher it suggests this scenario is in play.

This currency situation is already delicate before you add in the Trump factor which may tend to add even more volatility if he does not move very carefully. China appears to have its hands full already without added pressure from Trump, so we need to continue to watch that dynamic to see if Trump realizes that.

I think this is most likely the key event we need to watch this year that relates to what we try to follow here on this blog. Sharp currency movements that could spin out of control could certainly lead to the kind if monetary system problems we look for here and eventually even lead to monetary system change we also watch for here. The movement of the US dollar this year along with the yuan appears to be a key to keep an eye on.

Important added note: I had a brief email exchange with Jim Rickards on this issue and he offered this comment with permission to publish it here (underline is my addition):

"The China reserve and currency story is one of the biggest stories in the world, but it's a subset and a symptom of an even bigger story, which is the global dollar shortage. That not only affects China, but all emerging markets and the European banking system. Liquidity is drying up all over the world, but it's happening slowly so there's no sense of panic right now. That will come soon enough." --- Jim Rickards

Jim was on this topic early. Now I see lots of articles coming out discussing the problem China is faced with in relation to defending the yuan with its reserves. Jim identified that issue earlier this year (andwe covered it here). Jim donates his time (in email exchanges) and shares his thoughts in an effort to help provide the best information possible for readers and I greatly appreciate it.Added news note 2-21-17: I got this email alert from the BIS today:

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